Add a new page

Behavioral finance is a new field in finance, which has been the subject of an increasing amount of research over the last few years. Over the entire history of finance research, it has been believed that markets are efficient and that prices reflect fundamental values. One reason for these beliefs is that even if investors are biased, these biases should not be systematic. In other words, while different investors may have different biases, these biases should all wash out in the cross-section. In addition, even if investors are systematically biased, unbiased rational investors should be able to take advantage of these biases and irrational investors should eventually be driven out of the market – a survival of the fittest type argument.

Over the last decade however, a number of researchers have documented that, contrary to the efficient markets and portfolio theory hypotheses, anomalies can be observed in returns to firms after an enormous variety of corporate events – from mergers to share repurchases to stock splits.

Market prices reflect supply and demand. Aggregate demand can be usefully broken down into the demand of rational and/or highly sophisticated investors, which we’ll call arbitrageurs, and the demand of typical human investors. The survival of the fittest argument mentioned in the introduction says that sophisticated unbiased rational investors should be able to take advantage of biases of individual investors who should eventually be driven out of the market. This section examines the limits to arbitrage – why the arbitrageurs may not be able to return the markets to complete efficiency.